Why Second Price Bidding works for Google?

Let me begin by clarifying my intention to write this article is solely to depict some peculiarity of this subject and keep it free of any mathematics.

In order to get to the point where we begin our story, we need to clear the context; and we will do that in few simple points:

1. Auctioning is an old concept, used since Roman Empire as a mechanism to sell or allocate resources; Most common examples in recent times are eBay and Christie's
2. Google's AdWords started using auction based mechanism to sell advertisement spaces on their website since 2002
3. Most intuitive auction mechanisms are the Open Ascending-Bid Auction, and the First-price Sealed-Bid Auction where the words open, sealed, ascending and first-price clearly defines their workings

So, what does Google use for AdWords? As it turns out it is the Second-Price Sealed-Bid.

In fact Google generalizes the second-price idea to multiple item (and calls it Generalized Second Price auction), GSP. And this is the one people use to buy Google's AdWords. In fact, before Google, this mechanism was not seriously considered by anyone.

Let's first start with understanding what is Second Price auction,

• each interested buyer submit his or her bid for the item
• the buyer with the highest bid wins the auction
• finally, the winner pays price equal to the second highest bid

If this seems a little counter-intuitive, remember there is Mathematics to prove why this is an excellent mechanism to invoke Truthful Bidding & Social Welfare. But instead of going that route I urge you for now to take my word for it and just reflect on why that would be the case, i.e. Why Google use Second Price Bidding?

The simple answer to that question is precisely because of the decoupling between

• the allocation or winning result, and
• the pricing result

of an Second Price sealed envelope bidding auction. And this invokes the most desirable property of 'truthful bidding' being a dominant strategy for each bidder. That is, you tend to bid corresponding to your true valuation no matter what the other bidders might be doing. 

Finally, to understand this let's look at it this way, increasing price in an open auction is very intuitive if you want to win. But if you think about the price that you get to pay as the winner of a increasing price open option, 

1. your own bid determines how long you stay in the price war
2. but then when it stops, you effectively pay the bid of the last highest bidder, plus a small amount as increment you have put

Unless you overbid much more than you should, you effectively, paying the Second Price.

And therefore, Google AdWord's replicates the same intuitive Open Bidding mechanism using the Second Price Sealed Auctioning on the World Wide Web. In fact, as mentioned earlier Generalized Second Price is the auctioning mechanism Google run to sell their ad spaces. They cannot apply Second Price auction directly because there are multiple ad slots on each search result page. But unfortunately GSP is not truthful and doesn't maximize social welfare, however,

The reason Google uses GSP is because, it is simple enough to explain it's working to its diverse set of customers. And for them simplicity of explaining the auctioning mechanism is also very important consideration, even more than true valuation.

There is one other reason why Google may want to stick to GSP versus VCG, Vickrey-Clarke-Groves auction (which retains the true qualities of Second Price bidding), and that is customers are not always rational, they may have irrational behaviour.

Thanks

Abir Mukherjee